2011 Volume 4 Issue 2 Pages 159-167
We derive a new expression of investment criterion for real option models and give a new interpretation for the investment criterion. Given the required rate of return on investment r and the irreversible investment cost K, the investment criterion for deterministic cash flow X(t) is the marginal investment cost rK. For X(t) follows geometric Brownian Motion (GBM), we derive a new expression of the investment criterion has a form of marginal investment cost rK times a modification coefficient. This expression of the investment criterion is comparable to the criterion for deterministic cash flow. Thus our work leads to realizing the meaning of investment criterion for real option models more clearly. Moreover, we show the investment criterion for GBM with mixed exponential jumps can also be expressed by marginal investment cost rK times a modification coefficient that is more complex than the GBM's. Furthermore, this form of investment criterion eases the comparative statics analysis. Finally, we discuss the case of investment cost by also following GBM, and derive an expression of the investment criterion which is comparable to the deterministic case.
